Morgan Stanley sees dollar surge setting the stage for 'something to break'

Published Mon, Sep 26 20223:00 PM EDTUpdated Mon, Sep 26 20228:57 PM EDT

The U.S. dollar's strength is setting the stage for a crisis, as well as a looming bottom in the stock market, according to Morgan Stanley. With the greenback hitting 20-year highs against its foreign competitors, equity markets that have relied on cheap currency have tumbled. Fears are rising that the moves in the dollar will pressure corporate earnings, and "such US dollar strength has historically led to some kind of financial/economic crisis," Morgan Stanley equity strategist Michael Wilson and others said in a client note. A weak dollar makes U.S. goods and services less expensive in global trade, which is inflationary and not desirable while prices are around their highest levels in more than 40 years as they are now. Conversely, a strong dollar makes imports cheaper, which is not only disinflationary but also puts pressure on profits and raises questions about how much the economy can sustain until something goes wrong. The dollar's rise on Monday sent major stock market averages tumbling and brought on a fresh round of second-guessing regarding monetary policy from the Federal Reserve and its global counterparts. "What's amazing is that this dollar strength is happening even as other major central banks are also tightening monetary policy at a historically hawkish pace," Wilson wrote. "If there was ever a time to be on the lookout for something to break, this would be it." If there's a bright side, the dangers are pushing the stock market toward a bottoming process. Morgan Stanley estimates the S & P 500 will need to get in a range between 3,000 and 3,400, however, for the floor to hit and set the stage for a turnaround. The high end of that range translates to an 8% decline from Friday's close; the low end would mean a roughly 19% plunge. "The recent move in the US dollar creates an untenable situation for risk assets that historically has ended in a financial or economic crisis, or both," Wilson wrote. "While hard to predict such 'events,' the conditions are in place for one, which would help accelerate the end to this bear market." 'Exactly how' something breaks The Fed has raised rates a total of 3 percentage points this year, while dozens of other central banks around the world also have been tightening. However, in the UK, authorities actually have loosened fiscal policy, implementing a tax cut at a time when when inflation is running close to 10% on an annual basis. Morgan Stanley's currency team is expecting the dollar index , which measures the U.S. currency against a basket of its global counterparts, to continue to rise even though it's at its highest level since 2002. The firm forecasts the index to hit 118 by year end, up from the 114 level where it was trading Monday afternoon, indicating "no relief in sight, at least fundamentally speaking." "In our view, such an outcome is exactly how something does break, which leads to MAJOR top for the US dollar and maybe rates, too," Wilson wrote. "However, until that happens, we think the screws will only get tighter for earnings growth and financial conditions." The currency trends have ignited criticism for the Fed, which spent much of 2021 dismissing inflation as "transitory" as it continued to keep interest rates low and expand its balance sheet to about $9 trillion. Speaking on CNBC, Allianz chief economic advisor Mohamed El-Erian said the Fed had made policy mistakes "of historical proportions." Wharton professor Jeremy Siegel demanded that Fed Chairman Jerome Powell apologize to the American people "for such poor monetary policy that he has pursued, and the Fed has pursued, over the past few years."